Facebook mimics Apple by spending less on R&D

Mar 21, 2012

Social network giant Facebook is seeking to raise US$5billion in a public float.

Facebook spends a smaller per centage of revenue on engineering than other internet companies, mimicking Apple's strategy of keeping costs low by relying on outside developers for research and development.

Facebook devoted 10 per cent of its sales to R&D spending last year, a fraction of the level of some other companies holding recent initial public offerings, including Zynga and LinkedIn. Facebook, the biggest social-networking service, is planning its own IPO this year.

The company, known for its hacker culture and marathon coding sessions, has increasingly encouraged other companies to add features to its site. Lower expenses have given Facebook fatter profit margins than the typical prospective IPO, said Colin Gillis, an analyst with BGC Partners LP in New York. The challenge is maintaining that growth amid mounting competition from Google and younger startups.

“They are robust margins to be coming out of the gate with,” Gillis said. “Typically what happens is a company goes public and investors like to see margin expansion.”

Facebook's profit margin in 2011 was 27 per cent, up from 19 per cent in 2010 and 16 per cent the previous year. That tops the 14 per cent average for companies in the Standard & Poor's 500 Index.

Room to grow?

Excluding interest, taxes, depreciation and amortisation, Facebook's profit margin was 56 per cent last year. That doesn't give the company much room for improvement, Gillis said.

For now, Facebook is operating in the mold of Apple, the world's most valuable company. While Apple develops plenty of its own technology, it lets outside developers create the hundreds of thousands of apps that run on its iPhones and iPads. The approach keeps customers loyal to its hardware without R&D eating up as much revenue. Apple devoted 1.6 per cent of sales to research and development last quarter.

“We don't see any of the R&D spend by the app developers in Apple's numbers, but we see it in the result of the innovativeness,” said Ron Adner, an author and professor at Dartmouth College. “Same thing with Facebook.”

In Facebook's case, developers such as Zynga carry much of the weight. Zynga, based in San Francisco, offers the most popular games on Facebook's site, including “FarmVille,” “Mafia Wars” and “Words With Friends.”

Sales gains

For both Facebook and Apple, the relatively small R&D budgets stem in part from having booming sales. Facebook's revenue almost doubled to $US3.71 billion last year after expanding more than 150 per cent the previous year. It's a challenge to hire enough engineers to keep pace with that growth, said Avi Goldfarb, a professor at the University of Toronto.

“It's a very complicated process,” he said. “R&D is not something you can just throw money at and hope everything works out.”

Still, increasing competition for internet users and advertisers may push Facebook into stepping up its research spending. The Google+ social-networking site, started last year, has attracted more than 100 million users. Google also is making gains in display advertising - Facebook's main source of revenue. It's expected to take the lead from Facebook in the market for US display ads next year, according to research firm EMarketer.

Upstart rivals

To keep up, Facebook may have to spend 15 per cent of revenue on engineering, said Martin Pyykkonen, an analyst at Wedge Partners in Greenwood Village, Colorado. Newer rivals could quickly emerge to challenge its supremacy in social networking, just as Facebook itself displaced MySpace, he said.

Even so, Facebook's lower R&D spending doesn't mean the company is underinvesting in future products, said Nate Elliott, an analyst with Forrester Research in New York. Facebook has continued to roll out new products, including a revamped timeline feature for its profile pages and mobile services that let members show their locations.

“I would be more concerned if they weren't leading the social-media space in innovation,” Elliott said. “This is the social site that has done more than any other to introduce new features and new ways for consumers to interact with their property.”

And unlike Google, Facebook is dabbling in fewer projects that are far afield of its main business, Adner said.

“They're not out there coming up with driverless cars,” he said. “They're not out there coming up with solutions for solar energy. They're completely focused on their business. That probably increases the effectiveness of whatever spend we're seeing.”

Facebook's future research budget may hinge on the company getting a better idea of what areas it needs to focus on, said Sameet Sinha, an analyst with B. Riley & Co. For example, if it decides to pursue e-commerce more aggressively, that would put it in more competition with Amazon.

“Once they decide what's going on, what's going to be important for them, I think they will intensify their R&D efforts,” he said.